Is there even such a thing as a simple passive investment strategy?
Before rushing into ASX index ETFs or index hugging low fee LICs, there are many behavioural biases to think about. I will explore below what you should think about first to better equip yourself to this popular strategy.
Firstly, let’s get started early with the obligatory Warren Buffett reference you always come across from any financial article in the media. (Hey at least I didn’t put it in the headline with a huge picture like most do). I consider a key driver behind the popularity of ETFs in recent times is due to media attention given to Warren Buffett’s Berkshire letter in 2013 that discussed a strategy for the trustee for his wife’s inheritance. It was to place 90% in a low fee US equities index fund and 10% into short term government bonds. The four years since has seen a large portion of active fund managers under-perform the S&P500, which has added to the popularity of such a simple approach. Then there is the publicity surrounding Buffett betting that an S&P500 index fund will beat hedge funds, for a second time now.
I wish to make it clear I am not necessarily arguing against this method. I just wanted to point out that using simple strategies such as this will only succeed if you have the temperament to stick with them. I may be feeling my age but I have noticed younger investors embracing such strategies. Overall it is good to see them taking an active interest in finance and I can understand why ETFs prove popular amongst them. For those investors that didn’t have much of their wealth in the markets in 2008, they must look at the underperformance of active managers and wonder why everyone doesn’t go down the passive route. They probably have a healthy dose of scepticism to paying fees, and technology has seen new innovations such as robo advisors appeal to many, removing a lot of the hassles and costs of investing.
In choosing a simple passive investing approach though, you have arguably made a complex active large investment bet. Let me explain.
On what basis for example, may you have chosen the approach described above? Perhaps because one of the greats of the investing world mentioned it? The strategy was based on the assumption that an investor wouldn’t unnecessarily fiddle with it, apart from disciplined rebalancing. To be confident you won’t chop and change with a strategy, you need a deeper understanding of the inherent risks in it in the first place.
Right now it seems so easy. Since the 1970s though there have been four occasions that would seriously test the nerves of those with this approach. Bear markets in the mid-1970s, 2000 and 2008 produced slumps of around 40-50% in the major US share market indices. In 1987 the stock market crash saw the market fall by almost a quarter in one session.
Have you considered the appropriateness of a 90/10 stock/bond allocation for your own investing temperament?
Have you thought about whether having all your market exposure to a single country like the US makes sense? The US market is coming up as expensive on a variety of valuation metrics, significantly so when compared with the rest of the world. In a falling market you may have to read the news each day with all the financial experts in your head discussing the reasons why US shares are not the place to be. Can you remain loyal to your strategy in this environment?
ASX ETFs and the old low fee LICs
Do I just invest in AFIC or ARGO LICs?
For Australian investors, have you applied a similar strategy but to the ASX? Are you comfortable with more than a quarter of the portfolio concentrated in the four major banks? Renowned US value investor Bill Miller had a superb and consistent record of outperformance leading up to 2008, but when his sizeable bet on US financials came undone his reputation suffered. Already you must cope with many analysts suggesting the banking sector may be vulnerable to a slump in house prices and that the dividends may not be as reliable as many believe. There have also been many articles pointing out the large underperformance of the ASX this year compared to global markets. Can you hold your conviction that this strategy makes sense? If Australia ever has a recession again, can you stick to such an investing strategy when potentially it coincides with a bear market and you are reading about many Australians losing their jobs?
Ok then surely the answer is to diversify across other global markets I hear you say? Well then tell me which ones and what percentages! Are we now back to square one where you must come up with appropriate weights and now we need to make a complicated decision? I suppose we can choose a broad index like the MSCI World index. What happens then when you read about articles in the media pointing out some weaknesses with this index? Does it have too much exposure to developed economies facing headwinds from disappointing population growth such as in Europe and Japan? Does it make sense that China represents a large component of world growth but does not have an appropriately significant weighting in the index? Well maybe we can just apply our own little overweight there? Then you read an article about the debt build up within the Chinese economy and a crisis is looming, should I tinker with this China bet?
You could leave it up to a robo advisor, but without the in-depth knowledge of how they have worked out your allocations, will you keep the faith in the process if returns start to disappoint?
Oh, and I haven’t even begun to talk about the subject of currency exposure. Nor have I spoken about how often to rebalance, yearly or less often, or from a certain percentage deviation to targets? Then there is the question of which are the most efficient ETFs within certain categories.
The key takeaway I believe is to give plenty of thought to your own investing temperament and many other issues such as those described above. I am not bashing ETFs, because I think they are a fantastic development that are replacing a lot of the waste of fees that previously went to underperforming index hugging managers. I just think that there has been a few too many articles creating the impression that using them to meet your financial goals can be an extremely simple approach. i.e. requiring 10 minutes of reading time and copying an asset allocation you read from someone on the internet, or answering some very basic questions on your age and risk tolerance.
Sticking with a “simple” investing strategy can be an extremely difficult task. Do you meet many investors yourself that have applied a set strategy for more than a decade? It is human nature to want to tinker with things, and the set percentage allocations you decide on today may go against your changing beliefs in the future.
I think I counted 18 question marks in my article already, so does that reflect what some regard as a simple passive investing strategy? I am sure many readers of my blog think I try to over-complicate things with my ramblings, but just thinking about a passive investing approach is already even giving me headaches! It is something I can relate to, because I do have a gradual desire to tilt part of my investing to a slightly more hands off and uncomplicated approach over the next few years.
Maybe a solution is to simply buy Berkshire stock, but we also must be mindful that remaining loyal to an active manager can be even harder. Warren Buffett has had to remain convinced of his investing ability during some very large draw-downs and very long periods of under-performing the benchmark. Since 1980 we are talking of four occasions of losses in the order of 40 or 50%. This means approximately once every decade where his nerves are getting seriously tested, which may surprise some people to read. Then on various occasions many have questioned whether he can continue to outperform the index. A Barron’s article from December 1999 is famous for questioning whether Buffett had lost his touch, after a huge amount of under-performance during the tech boom. It is even somewhat ironic that in this latest bull market, Buffett’s performance doesn’t look that special when comparing to the 90/10 approach that I discussed earlier.
If you are thinking the share market since the last global recession has been an easy game of low fee market exposure then perhaps consider a quote I came across when watching a recent Ray Dalio interview, “If you don’t worry, you need to worry. If you worry, then you don’t need to worry”. Back in March 2009 there was a lot of worry, but investment returns since have showed there was no need to worry at that time. Things have changed quite a bit since then.
Finally, my sincerest apologies for those clicking on this article hoping to read about a simple investing strategy to apply, I have failed miserably on that front! Hopefully though some newer investors to the markets since 2008, may think a bit more deeply to the latest “simple” investing approach they have copied from someone off the internet. It then may give them the understanding, conviction and temperament to stick with a “simple” strategy and make it successful. I do believe if one gives plenty of thought to their investing strategy and is well prepared, they can succeed with a basic approach using low fee ETFs. I wouldn’t necessarily describe it as easy though, your conviction regarding your strategy is likely to be given a major test on many occasions.
Here is one example of how it can be difficult to stick with the original investment strategy you develop. I don’t know how things turned out for this guy and I am not trying to criticise, I just found it interesting. The article appeared within the week of the US share market bottom in 2009.